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Ex-Wife’s Share of Military Retirement Payments Is Subject to Tax

By James Beavers, J.D., LL.M., CPA

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The Tax
Court held that a taxpayer’s share of her ex-husband’s military
retirement payments was subject to tax despite the fact that a
domestic relations order specified that taxes were to be
withheld from the payments before the taxpayer’s share of the
payments was determined.

Background

Maria
Mitchell was formerly married to Bobbie Walton, a member of the
U.S. Air Force (USAF). Walton and Mitchell divorced in
California, a community property state. Under a qualified
domestic relations order (QDRO) issued after Walton’s retirement
from the USAF, Mitchell was awarded one-half of the community
property interest in Walton’s net disposable military retirement
pay. The QDRO defined net disposable military retirement pay as
gross retirement pay less a variety of deductions, including
withholding for income taxes.

After Walton’s retirement
in 1991, Mitchell began receiving payments from the Defense
Finance and Accounting Service (DFAS) for her share of Walton’s
retirement pay. Mitchell did not include the payments that she
received in income in any year. In 2003, the IRS sent Mitchell a
notice of deficiency for tax on the payments she received in
2001. Mitchell filed a petition with the Tax Court challenging
the notice of deficiency.

Mitchell argued that the
payments she received for her interest in Walton’s military
retirement pay were not subject to income tax because the QDRO
specified that the DFAS should have withheld all taxes from
Walton’s military retirement pay before it divided and
distributed the pay. Therefore, according to Mitchell, the DFAS
should have withheld taxes on the full amount of Walton’s
retirement pay before it paid Mitchell her share. Because the
DFAS did not do this, Mitchell contended that if she were
required to pay tax on her share, then Walton’s retirement pay
would be subject to double taxation, having been taxed once when
distributed to Walton and again when Mitchell received her
share. The IRS countered that although the DFAS withheld tax on
Walton’s retirement pay, it only withheld tax on his share of
it.

Tax Court’s Decision

In a decision reviewed by
the full court, the Tax Court held that Mitchell’s arguments
were without merit and that the retirement pay she received was
taxable. The Tax Court found that the method of calculating the
portion of Walton’s retirement pay to which Mitchell was
entitled had no bearing on whether the payments she received
were taxable, nor did it mean the payments were exempt from tax
because tax had already been withheld from them.

According to the Tax Court, the method of calculation
specified in the QDRO merely defined Mitchell’s property rights
in Walton’s military retirement pay, not the tax consequences of
her receipt of the benefit. Under California community property
law, Mitchell was liable for tax on those distributions,
regardless of how their amount was calculated under the QDRO.
Finding that Mitchell had provided no other evidence that the
payments had been subject to double taxation, the Tax Court held
that Mitchell was subject to tax on the payments she
received.

Reflections

Mitchell had previously
litigated the same issue with respect to the retirement payments
she received in 2000 in a Tax Court small case proceeding
(Mitchell, T.C. Summ. 2004-160). Although the Tax Court did not
address the argument, the IRS contended that because she had
already litigated the issue, Mitchell’s case should have been
dismissed under the doctrine of collateral estoppel, which bars
relitigation by the same parties of an issue that has already
been decided in a previous case.

In a concurring opinion,
Tax Court Judge Holmes argued that the Tax Court should have
availed itself of this opportunity to rule on whether a decision
in a small tax case estops a party from litigating the same
issue in a regular tax case. While on previous occasions the Tax
Court has said that it would apply collateral estoppel to small
tax case decisions, the fact that it heard and decided the
second Mitchell case seems to contradict that stance. While the
small case decisions are without precedential effect, Judge
Holmes argued that the Tax Court’s decision means “that they are
without effect on future litigation at all.”

Mitchell, 131 T.C. No. 15 (2008)

The reports of cases, rulings, etc., herein, except for the
Reflections, are edited versions of the relevant court
opinion, published ruling, etc.

The winner of The Tax Adviser’s 2014 Best Article Award is James M. Greenwell, CPA, MST, a senior tax specialist–partnerships with Phillips 66 in Bartlesville, Okla., for his article, “Partnership Capital Account Revaluations: An In-Depth Look at Sec. 704(c) Allocations.”

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